How a bankruptcy code could improve the financial system

The new bankruptcy code is going to be a reality soon. There is already groundwork done by the new government. A little over a year ago, Finance Minister Arun Jaitley set the stage when he announced an "entrepreneur friendly legal bankruptcy framework". This was followed up with the setting up of the bankruptcy law reform committee, which studied the existing laws and new legal framework. Six months ago, it submitted its preliminary report. The final code will be out once there are deliberations within the government and also with the stakeholders outside.

Let's look at how the new bankruptcy code will change the life for lenders especially banks, corporate borrowers, the banking system as a whole and also for the economy.

Protect the rights and interest of lenders: The new code would protect the rights and interest of lenders, especially banks. In India, banks are the big source of funding the corporate sector as debt markets are not well developed. The banking system also depends on individual savings to lend to the corporate sector. Under the current legal framework, the bankers are at the mercy of promoters or corporate borrowers who try every trick to delay the process of restructuring or recovery. There is a debt restructuring mechanism to revive an asset or approach debt recovery tribunal and invoke SARFAESI Act to recover the loan.

Early treatment of financial distress: Today a lot of time is wasted in early recognition and treatment of a case of financial stress. In US, the action under Chapter 11 and Chapter 7 works very efficiently to restructure or sell an asset to an interested party. Today, due to multiple lenders in a single company, it becomes very difficult to bring all the lenders on a table. While the RBI has been encouraging banks to sell bad loans to asset reconstruction companies (ARCs), the ARCs themselves have to approach the same DRTs or invoke the SARFAESI Act to revive or recover the money. The rogue promoters or lenders also have a recourse to approach the civil courts challenging the sale /DRT orders etc.

Preservation of assets: At times, the asset loses its value because of the delay in the process of restructuring. Timely action will minimise losses and help the asset regain its value or productivity.

Release of resources for banking system: Today, the stressed assets in the system are over 10 per cent of the total loan books of the banks. Many of these assets are not paying interest or the principal amount. Some are locked in legal battles in various courts. The bankruptcy code will create a deterrent in the system. This will help in releasing such locked resources for other productive lending, which in turn will help in loan growth, profitability and employment. A large stressed or bad book also restricts the banks' ability to reduce interest rates in line with the base rate cuts by the central banker.

Helps the economy: When a company fails, it has implications for creditors, shareholders, suppliers, employees, etc. The corporate failure also has implications for the economy as there are hundreads of suppliers connected with the company or employees. The ease of resolving insolvencies is also a very critical factor affecting the ease of doing business in a country. In India, this can be a big stumbling block for foreign investors willing to set up factories in India.